European collateralized loan obligations are deleveraging more rapidly than might be expected after their reinvestment period ends, according to Fitch Ratings.
Excluding older deals that have more flexibility to reinvest, most CLO portfolios have repaid close to 20% of their liabilities one year after their reinvestment period ended.
Fitch said this is surprisingly high, considering that the low cost of funding, which reflected market conditions when pre-crisis CLOs were originally priced, gives managers incentive to leave senior notes outstanding and put cash to work in relatively high yielding loans. It is also surprising given the number of European corporate borrowers that amended the terms and the maturities of their loans when they come due, rather than refinancing them. Up to 34% of obligations held by European CLOs are amended and extended.
One reason for the relatively rapid deleveraging is that some loans that CLOs held in their portfolio have been refinanced with high yield bonds. Europe’s junk bond market is much smaller than its U.S. counterpart but has growing rapidly. Nevertheless, CLOs that incorporated ratings in their reinvestment criteria and whose senior notes have been downgraded have been unable to reinvest proceeds of repaid loans.
Reinvestment capacity for pre-crisis deals is declining. Some 60% of Fitch-rated transactions have passed their reinvestment period, and by the end of 2014, all of them will have done so. This means managers will only be able to reinvest unscheduled principal proceeds, or proceeds from the sale of "credit impaired" or "credit improved" obligations (which can largely be defined by the manager).
The ability of CLO managers to invest in high-yield bonds may keep one funding channel open to below investment grade companies, but the end of reinvestment periods signals a contraction in the availability of cheap credit for these borrowers compared with before the crisis.
CLO managers and investors have learned their lesson. The adverse impact of amend and extend activity on senior CLO noteholders, and in particular the net present value loss from delayed repayment, is reflected in the new placed deals that have emerged since the crisis. Investors' desire to ensure they get their money back sooner is resulting in shorter non-call periods, shorter reinvestment periods (typically between three and four years, compared with five-to-six years pre-crisis) and a shorter weighted average life (typically between seven and eight years, down from 10-11 years before the crisis).